• SDS     +6.51%
• DTO    +1.00%
• VXX    +9.72%

Remember these positions all represent net short market trades and are to be used only within an acceptable range of risk. These vehicles are all very volatile, so we highly recommend readers to subscribe to our “Complete DS Analysis” feed in the right sidebar and our DS SHOUTBOX trading notebook feed @http://twitter.com/ds_shoutbox. The DS SHOUTBOX will give readers notifications of any trades made after the close of each trading day, while real time trade alerts are only available to private clients.

If you are interested in becoming a private client, feel free to email our Lead Trader and Analyst Robert Eberenz at Robert.eberenz.iii@gmail.com.

VXX (iPath S&P 500 VIX Short-Term Futures ETN), 1-yr chart on 05-28-10

Trade: Short the S&P 500

Time Horizon: 5-20 Trading Sessions

For the first time in a LONG time it’s becoming safe to bring on short positions relative to the S&P 500 equity index. The S&P 500 p/e ratio adjusted for inflation remains above 20 @ 21.13 as of Friday’s S&P 500 close @ 1089, which suggests that the recent correction on the S&P has further to decline before it reaches fair value.

SDS (ProShares Ultra-Short ETF), 6-mo Chart on 05-28-10

While we don’t feel comfortable going long the S&P 500 at any p/e level above 15, given the trend of rising interest rates, we understand that risk takers will re-enter the market at higher current p/e valuations. So we’re recommending this play as a short term position (i.e. 1-4 weeks or until reaching our profit target). Using the ProShares Ultra Short S&P 500 ETF (SDS) we can get relatively liquid 2x inverse exposure to the S&P 500 (recently +50 million shares/day). While we’re looking to capitalize on instability and unresolved risks in the EU, trading the SDS will give traders short exposure to a basket of U.S. equities and avoid short term fluctuations  in similar vehicles tied directly to the EU.

Trade: Short Crude Oil

Time Horizon: 5-15 Trading Sessions

We made a call to short Crude at $79.69, calling a price target of $70 /brl for the WTI continuous spot price and we cashed out when the WTI price hit that level. After closing that position at a profit, our hunch was confirmed. The uptrend in inventories had fought the rumors of accelerating demand for gasoline and mediocre distillate consumption, and instead that macro-economic and geopolitical forces are now leading prices.

WTI Continuous Crude Spot, 1-Yr Chart on 05-28-10

You may notice that the MACD histogram would disagree with our position, however the flight from risk trade is back on and we are going against our technical instincts to put an opening stake into DTO at 75 bucks. We also have a buy trigger set at $80/shr which will give us short exposure when the WTI near month contract prices near the 50 day sma at $77.

The European Confidence report and the Chinese Industrial Purchase Managers survey have added to uninspiring anecdotes concerning bond market weakness in the U.S., Europe, and China, to reassure us of our bearish positions here.

Some readers will like none of these strategies, while others will find them all interesting at these levels. Remember to do your own research and by all means tell us why we are RIGHT or WRONG in the comment box below!

Factors Affecting WTI Spots

The BP Gulf spill, gasoline demand reaching 3.5% yoy, prices at the pump at $3.00, refinery capacity above 89%, Cushing, OK crude storage dwindling to 14 million barrels, tankers holding countless barrels off the coast, OPEC members breaking quota, unrest in Iran, and sovereign default contagion in Europe have been on the radar of “black gold” speculators for the past two months. These realities are the extension of maturing trends over the range bound past two months, but only one has significantly altered WTI Crude prices. A casual deduction might blame oil’s price destruction on a stronger Dollar, due to the recent flight from all things Euro. Contrarily, we see default risks in the EU and retrenching speculation creating the vacuum through which industrial commodity prices, most notably Oil, will fall.

WTI Continuous Crude Oil Spot Chart

In January we correctly called a bearish trend reversal in Crude Oil prices and predicted the fall to $70 / barrel. Our prediction seemed far fetched at the time, while Crude was trading near $80, but we were right then in identifying the speculative forces surrounding crude oil. Now discounting for newly developed sovereign default risks in the EU and the effects of a plummeting Euro on the price of all industrial commodities, we foresee a very similar reversal the second time around.

Technicals

The MACD peaks have continued along the negative sloping trend line, congruent with a bearish wedge reversal, while recent events regarding the Greece bailout have had direct impacts on the price of the WTI continuous Crude Oil spot price. In April, the WTI spot reached the $87 mark in intra-day trading three times, but each time closed lower and weaker than the last. The Relative Strength Index (RSI) now reads below the neutral 50 mark, suggesting that momentum has reversed and bearish sentiment is now leading prices.

Greek Contagion

Wedensday, April 28 through Friday, April 30, Crude Oil climbed near it’s yearly high of $87 on rumors that led to PM Papandreou accepting a 110 billion Euro bailout from the EU on Monday, May 3. On Monday, the price of crude again reached it’s $87 high intra-day, before closing just above $86.

Greek Bond Spreads to German Bunds, 2yr & 10yr Maturities (April 22, 2010)

So why did crude oil sell off in the wake of this “stability” in the EU? We would argue that the situation surrounding the Greek debt crisis is now anything from stable, and has in fact grown to an unstable monster that could drown much more than just Oil and EU stocks. We don’t claim to have any inside edge on the contagion risks of defaults in the EU, but we do trust a certain Mohamad El-Erian, of PIMCO’s total return bond fund, the largest bond fund in the world. El-Erian appropriately warns, “it is far from assured that this program will forcefully counter contagion risk,” as seen in the recent chart (left), compliments of Business Insider. In the time since this chart was built Greek yields have rocketed even higher, where on May 5, 2010, Greek 1o yr spreads over German Bunds rose to above 700 bps, putting the headline yield on Greek 10 yr bonds above 10.5%.

Austerity measures in the form of  pension reductions, bonus cancellations, and job cuts are planned to cut Greece’s budget by 13 billion Euros, in exchange for EU loans at 5%.  Naturally, markets don’t like the deal, since the EU is absolving Greece’s bad debt at a loss, where the interest on the loan to Greece is half that of the market yield for 10 yr debts.

So how are the Greeks taking the medicine? We’ll let you judge for yourself in this week’s DS Video, compliments of CNBC, covering the the budget cut protests.

The Future of Crude

At this point it isn’t crucial that the EU break up for Crude Oil to fall to $70 or below. 2010 gasoline demand is trending towards 3.5% as prices at the pump average above $3/gallon in the U.S., but leading indicators seem to be topping, as the ISM non-manufacturing new orders component trended lower and retail sales are narrowing closer to 2% yoy for April. The past 12 months have been an atmosphere of loose money and speculation, while globally growth has recovered due to stimulus packages and corporate spending supported by higher equity valuations. All in all, we see global energy demand near it’s peak, given (Quantitative Easing) QE cooling in China and European weakness due to Euro-zone cost cutting.

Our analysis supports the position that Crude Oil spot prices still reflect a great deal of recovery linked speculative forces. Further, moderate gains in demand for crude and distillates are countered by the bulging supply of U.S. inventory and OPEC member countries producing above quotas, partially to fund stimuli plans and state bailouts of their own (e.g. Dubai World).

The only recent game changer for Crude Oil has been Greece and the ensuing sovereign default contagion risk. We are playing this risk using crude oil, because the volatility allows for large price swings to capture gains with positive correlation to the situation in Europe. Finally, the ceiling for WTI spot prices is a firm resistance level ($87), and therefore much safer than the erratic behavior of direct EU crisis plays (e.g. Greece, Spain, Portugal Bonds, the Euro, Euro Equities, etc.). Specifically we like DTO (Powershares DB Double Short Crude Oil ETN), since it’s generally liquid enough for our taste (500k-1 million volume/day), and tracks -2x the WTI Crude Continuous Spot.

Disclosure: Long DTO Over the Next 2-4 Weeks

Fundamentals

Crude supply rose by 5 million to 330 million barrels in the past two weeks, still above average market high water mark levels. Despite a large draw from the 375 million barrel supply peak in May 2009, refiners are voicing their concern by halting production capacity just above 81%. Crack spreads are increasingly narrow as weak consumer habits choke the profitability of refiners and discourage production managers from adding to the more costly finished good stockpiles (i.e. gasoline, distillates, etc.). When crack spreads rise alongside prices, refiners benefit from higher gas prices by increasing their margins. However, stagnating crack spreads near all time lows signals weaker consumer demand for final petroleum products, forcing refiners into slowing production to keep spreads at current levels. In short, higher oil prices are hurting refiners and consumers in an environment where end demand for energy is not responsible for price gains.

Graph of brent crude oil spot price vs. European gas - oil crack spread, January 2010

International Energy Agency (IEA) World Oil Demand

The fundamental global price function of supply and demand should be respected, but IEA have recently been misstated by oil hawks. The International Energy Agency has predicted global demand for oil to begin at 86 million barrels per day (mb/d) in Q1 2010 and finish Q4 near 87 mb/d. While these estimates may have risen from earlier expectations for weaker demand, the upward price momentum has been baked into stocks.

IEA Wolrd Oil Supply 2010

The 2010 mean demand estimate of 86.3 mb/d compared to December global supply of 86.2 mb/d, on an unexpected rise of 270 kb/d, suggests that supply is gaining while demand growth, rooted in non-OECD developing Asian countries, is less than stable. Also important are upside supply surprises from the OPEC 12, which prove that there are incentives for the cartel member states to raise production levels at these prices.

Sentiment

Rooted in U.S. equity values lie traders’ economic sentiment. Crude oil prices are historically volatile during periods of uncertainty, where the commodity reflects market participants’ confidence in the economy as a whole. Bullish sentiment has been on the rise for much of the previous year, as traders have been talking up the potential for crude to hit $90 per barrel. This optimism has been rooted in the manufacturing expansion in the second half of 2009, GDP expansion in Q3 and expectations of expansion in Q4, and global demand upgrades by the IEA mentioned above. Though mainly, there is the $144 per barrel price hemorrhage of July 2008 fresh in traders’ minds and expectations for a lasting economic recovery in 2010. These factors have combined to create a short averse commodity trader’s market, where resistance levels have remained weak as rallies occur.

As you may have already guessed, we consider prices to be floating on a thick layer of froth, aided by the mentality that oil will continue a sustainable rise, despite the 130% rally from February ’09 to January ’10. The catalysts necessary to cause this confidence shift are simply the reverse arguments of price inflating factors that are now being proven overblown.

First, the manufacturing recovery has outpaced most expectations, as ISM Manufacturing Surveys show positive forward indicators of growth, inflating expectations to levels where the probability of upside surprises is greatly reduced. Second, the manufacturing sector has contributed largely to GDP expansion in Q3 and is expected to carry the U.S. economy towards +3% growth in 2010. Future disappointments from the goods producing sector would not only implicitly hurt oil, but would indirectly lower crude prices as the forecasts for broad based economic growth are revised lower. Third, the IEA estimates for Global demand for crude oil are overblown and supply is increasing more rapidly than predicted. All the while, a public announcement from China proclaimed that QE in response to the economic recession is now being reversed, causing the market’s expected rate of energy consumption to be revised lower.

Wrapping up, Q4 earnings results seem to be less positive than Q2 and Q3, where specific results from financials and transports have so far bode badly for animal spirits. Further write downs from JP Morgan (JPM) & Citi (C) on credit card defaults and foreclosures have pushed the consumer’s recovery further down the time line, while CSX Corp. (CSX) reported lower transport volume, dampening the spirits of bulls citing manufacturing growth during the period.

Technicals

While fundamental analysis and sentiment shifts are both worth pointing out, the technical support to one’s argument is always most crucial to a high conviction trade. Glance over the visual below, then we will discuss the technical signals in more detail.

West Texas Intermediate (WTI) Crude Spot Price (NYMEX Crude)

The bearish wedge pattern is a classic technical pattern, where market prices for an underlying security increase over a period of time, but growth between peaks shrinks while growth between troughs is sustained. In this cycle, the Moving Average Convergence to Divergence (MACD) graph and histogram show weakening moving average momentum, as depicted by the downward sloping trend between peaks on the MACD
sub-chart. While the wedge has been forming for some time, two further technical signals support now as the turning point for crude prices. The first signal comes from the 50 day simple moving average (sma) at $77.50, which prices broke beneath more than once in futures markets on Monday, before the WTIC closed higher at Tuesday’s close. The second and most convincing sign came when the MACD histogram broke below zero, marking a bearish cross. Had trading momentum led to higher price levels and an MACD reversal above the most recent rally peak in late October, the bearish wedge would not have formed and crude prices could have consolidated to move higher. Instead, we saw a perfect lower peaking reversal to complete the bearish wedge and seal this call.

The WTI continuous spot, charted above, closed at $79.32 on Tuesday and will allow for a better entry point for oil shorts on Wednesday. We own the PowerShares Double Short Crude Oil ETN (DTO) and added to our position at $79 dollars. The vehicle attempts to provide 2x inverse price movement compared to the WTI crude oil spot.

We are setting a price target for the WTI spot at $70, where we will take profits from our DTO position and reassess our position.

Disclosure: Long DTO

The oil issue has been speculative to this point. It's hard to argue against 90 dollar oil when we saw 145 in July 2008, but the fundamentals aren't congruent with the price growth we've seen and this trader finds it easier to argue FOR $60/ barrel oil. Crude supply in the U.S. remains high, at 330 million barrels, while gasoline demand remains week and imports are rising. Crack spreads for refiners are reflected in their output averse management of facilities, where capacity utilization rates have stagnated at 81.3%. Refiners are the effective buyers of crude and the capacity numbers are sending signals of distress. The IEA's world demand predictions for 2010 were recently raised from the current 2009 level of 84.9 Million Barrels / Day (mb/d) to nearly 87 mb/d by 2010 Q4. (It should be noted that predictions for Q4 2009 global demand at 85.5 mb/d overshot the actual level of 84.9.) Rate hikes in China this week will calm the giant and should increase the likelihood of U.S. rate hikes in the first half of 2010.

Rate hikes will cool speculative trades and pull a significant amount of upward speculation out of Crude, as they increase capital holding costs and the risk of trading on margin. Softening Chinese growth will also cool global supply and demand speculation, with respect to crude, in an equally bearish development for the commodity.

The Consumer

Earnings season may present upside risk to short positions, which is why our stops have been tightened on our SDS and SCC positions. SPX might make it's way to 1200 where a lot of traders are calling the next Fibonacci resistance level, but momentum seems to be sputtering as earnings have begun.

The December Retail Sales report showed -0.3% growth combined with the revised higher 1.8% November rate, and makes it difficult to gauge buying sentiment moving into 2010. However the negative growth in the month of Christmas will leave many scratching their heads, and suggest that energy prices are playing a bigger role in retail sales than previously thought.

All in all, crude seems to be weakening, even on the backs of solid earnings from Intel, which should have been interpreted as positive to the overall economy. In after hours trading Intel traded up around 0.8% on a 0.55 EPS report vs. 0.34 EPS expected. Granted the day saw some sour economic fundamental data from the previous mentioned reports, but the market response was weak for a 62% profit beat.

Financials

Markets are becoming tougher to surprise at these levels and we could see more weakness from the banks. Soc Generale (SCGLY.PK) had an awful quarter in France and the U.S. regional First Midwest Bancorp (FMBI) missed the -0.07 EPS consensus by 76 cents, at -0.83 EPS. If regional financial problems due to MBS and the potential for more mortgage pain continue to show their fangs, financials could sell off through earnings.

Financials are the guts of the recession and will surprise many at how fast they can lower the tide for all. JP Morgan (JPM) will answer questions in this category on Friday, where weakness from the best in breed lending giant would create malignant concern in the banking sector at large. 

Disclosure: Long SDS, Long SCC, Long DTO (see: DS Portfolio)

While Alcoa is only one company, the firm is symbolic of the U.S. manufacturing sector as a whole and it’s profits are directly affected by the prices of input commodities, primarily petroleum products and aluminum ore.  Below is a 1-year chart of the S&P 500, annotated according to AA earnings results vs. estimates. (Click chart to expand in a new window)

As shown above, the S&P 500 has rallied from the announcement of AA earnings following each of the past three quarterly announcements. The once discarded industrial giant has found new importance over the past year in financial markets as it foreshadows the industrial earning power of the U.S. The recent two quarterly results beat estimates, while the Q1 2009 results were very near the street’s consensus at the end of a period wrought with massive earnings let downs. All in all we see the first three AA quarterly results of 2009 as better than expected.

Naturally, Alcoa can’t dictate the earnings of an entire economy, but the two factors causing the firm to miss earnings will be applied to bottom lines as earnings season picks up in the following weeks. These factors were higher energy and aluminum ore costs combined a weaker U.S. Dollar. The macro economic message heard on Wall Street highlights real revenue destruction from a weaker domestic currency and the negative cost effects of higher oil.

The following two charts show the trend of these two factors of production below in the form of the USD index and the WTI Continuous contract.

Referring to the charts, the cost of petroleum based inputs to production and the devaluing of the U.S. dollar during the months of October to December 2009 are both evident. Immediately, traders and investors have begun applying heavier weights to these parameters when running their earnings models. Will this trend be the thorn in the side of earnings to bring the first season of the recovery where earnings miss more than beat estimates?

In our opinion the dollar has held it’s ground fairly well over the past month and may see a short term appreciation on interest rate concerns, while we view crude oil as overbought and due for a pullback. We follow the Moving Average Convergence Divergence technical series, as it has been highly predictive of price cycles in the many securities, mainly crude oil, over the course of the recovery, and see crude oil particularly overbought with respect to this statistic.

Whether earnings season is a make or a break for stocks relies on more than the results of just one firm, yet the manufacturing recovery story has remained the golden goose of 2009 and will not benefit from the implications derived from a negative AA earnings card.

Disclosure:

Currently we are short Crude Oil (DTO), short Consumer Services (SCC), and short the S&P 500 Index (SDS).

(By Clicking on the DS Portfolio tab in the navigation bar above, readers can follow the current portfolio held by Diamond Slice partners in real time.)